Using panel structural VAR analysis and quarterly data from four industrialized countries,
we document that an increase in government purchases leads to an expansion in output and
private consumption, a deterioration in the trade balance, and a depreciation of the real exchange
rate (i.e., a decrease in the domestic CPI relative to the exchange-rate adjusted foreign CPI).
We propose an explanation for these observed effects based on the deep habit mechanism. We
estimate the key parameters of the deep-habit model employing a limited information approach.
The predictions of the estimated deep-habit model fit well the observed responses of output,
consumption, the trade balance, and the real exchange rate to an unanticipated government
spending shock. In addition, the deep-habit model predicts that in response to an anticipated
increase in government spending consumption and wages fail to increase on impact, which is
consistent with the empirical evidence stemming from the narrative identification approach. In
this way, the deep-habit model reconciles the findings of the SVAR and narrative literatures on
the effects of government spending shocks.